Why Investors May Be the Ones Who Are High

In the past several weeks, investors in Canada’s medical marijuana industry have finally received news which allowed them to become excited. As a result of the clarity offered by some provincial governments regarding the distribution of the substance, investors in Canopy Growth Corp. (TSX:WEED) have seen the value of their investments increase in value by more than 20%, in spite of the news not necessarily translating to any increase in profitability. Although many investors have been pounding their fists, arguing the potential for long-term profitability as a justification for investing in this sector, the long-term outcome may be far worse…

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In the past several weeks, investors in Canada’s medical marijuana industry have finally received news which allowed them to become excited. As a result of the clarity offered by some provincial governments regarding the distribution of the substance, investors in Canopy Growth Corp.(TSX:WEED) have seen the value of their investments increase in value by more than 20%, in spite of the news not necessarily translating to any increase in profitability.

Although many investors have been pounding their fists, arguing the potential for long-term profitability as a justification for investing in this sector, the long-term outcome may be far worse than many expect. When considering the industry through Porter’s five forces framework, it is easy to see why the industry will never return above-average returns for any extended period of time. The five factors are power of suppliers, power of buyers, threat of substitutes, threat of new entrants, and intra-industry rivalry.

As the producers or growers are essentially the manufacturers of the product, the relationship with suppliers is not a hugely important one. As long as marijuana growers have a licence from the government and employees willing to work, there will be no issues with suppliers. The power of buyers, however, is a completely different story.

Given that each provincial government has the opportunity to create their own monopoly over the distribution of the substance, each buyer will exercise significant power over producers. Assuming each province is the only customer, there will be only 10 or so customers across the country, each one with a significant amount of red tape and what amounts to omnipotent power when dealing with producers.

The third and fourth factors to consider are the threat of substitutes and the threat of new entrants. Although new entrants can be limited due to the government being required to issue permits to each producer, the law also allows for each adult to grow a limited number of plants for their own personal use. With anyone allowed to grow a product which is essentially no more than a weed, the availability of the product from home may put a ceiling on the company’s ability to command higher than normal revenues. According to this, excess profits will never be profitable.

Currently, there are no competing drugs that are legalized for everyday use in the country. Alcohol, however, may be viewed by many as a substitute product.

The last factor to consider is the degree of competition within the industry. Although a growing pie is most often a reason to avoid a high degree of competition, the truth is a very new industry with many emerging companies. I can easily see new competitors trying to survive by dropping the price over time. Only time will tell.

After weighing the qualitative factors of the industry, investors may be best to think long and hard before investing any substantial amount of money in this sector.

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Fool contributor Ryan Goldsman has no position in any stock mentioned.

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